Let Me Explain Why Wells Fargo's 1st-Quarter Earnings Were Better Than They Appeared

For the first time in 19 quarters, Wells Fargo reported earlier this week that its quarterly net income dropped on a year-over-year basis.

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This ended an incredible streak that transformed Wells Fargo into the most valuable bank in America, measured by market capitalization, even though the California-based bank is nearly a third smaller than JPMorgan Chase in terms of the assets on their respective balance sheets.

At first glance, Wells Fargo's shareholders would be excused for lamenting the end of this trend. But the reality is that this is nothing to be concerned about.

Consider this: Since the first quarter of last year, Wells Fargo's balance sheet has expanded by $191 billion. That's equivalent to swallowing SunTrust Banks, the eighth largest traditional lender in America, in one fell swoop.

The problem is that these assets aren't as profitable right now as they were in the past, or, more importantly, as they're bound to be in the future. This is because interest rates are still virtually as low as they can realistically be expected to go.

All told, Wells Fargo generates 52% of its revenue from its $1.5 trillion portfolio of interest-earning assets. In the year-ago quarter, it netted a 3.2% return on these assets. But in the latest quarter this fell to 2.95%.

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It was the first time the bank's so-called net interest margin dipped below the 3% threshold in at least a decade.

By my calculation, the decline in Wells Fargo's net interest margin accounted for more than $1 billion worth of effectively forgone net interest income in the first quarter alone. Holding all else equal, that would have boosted Wells Fargo's earnings on a year-over-year basis by 17%.

What's important to appreciate, moreover, is that at least some of the decline in Wells Fargo's net interest margin was intentional. Over the past year, the bank's loan portfolio, which yielded 4.19% last quarter, grew by $34.8 billion. Meanwhile, its portfolio of interest-earning repurchase agreements, which yielded a mere 0.28%, expanded by $68.5 billion, and its holdings of investment securities, which yielded 3.08%, increased by $54.4 billion.

The point is that Wells Fargo is doing exactly what it should be doing right now. As opposed to juicing its current net income simply to prolong its streak of quarterly earnings growth, it's staying highly liquid in preparation for a time when interest rates rise. It's a smart move that will pay off in spades once the inevitable increase comes to fruition.